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As target-date funds continue to assume a larger role in retirement

plans, the need for benchmarks that can help communicate

an accurate comparison of a target-date fund’s risk profile will

become more pronounced. In this article we discuss some

of the major challenges in benchmarking target-date funds and

describe Morningstar’s approach.

Benchmarking Target-Date Funds: A Slippery Slope Selecting an appropriate benchmark to evaluate the performance

of an investment fund is one of the most important steps in

performance measurement practices. The CFA Institute curriculum

defines a benchmark as “a collection of securities or risk factors

and associated weight that represents the persistent and promi-

nent investment characteristics of an asset category or manager’s

investment process.”

Evaluating a target-date fund or family of target-date funds is far

more challenging than evaluating traditional single-asset class

funds. Investors benchmark a traditional single-asset class fund

against a passive index to see how much value the manager

added, where the benchmark represents a relatively agreed upon

weighting scheme for a relatively agreed upon set of potential

investments. In such a case, the established benchmark index

helps define the portfolio manager’s opportunity set and serves as

a yardstick for performance comparisons. When it comes to

target-date indexes, however, there is a lack of consensus on the

opportunity set of potential investments (i.e., which asset classes

should be part of the benchmark) and the weighting scheme for

the opportunity set of potential investments.

A fund can outperform purely based on a favorable asset allocation,

even if each of the underlying securities (or funds) trailed their

respective benchmarks, or vice-versa. Unless investors investigate

the source of the fund’s performance, they could falsely assume

that the manager is adding value through security selection when

in reality it might be due to the fund’s asset allocation glide path.

Despite the challenges of benchmarking target-date funds, the

importance of having an appropriate benchmark cannot be over-

emphasized. There are a number of different stakeholders

with distinct needs for an appropriate target-date benchmark:

1. Plan fiduciaries/plan sponsorsOne of the principal responsibilities of plan fiduciaries, such as

fund directors or plan sponsors, is to oversee the performance

of the fund’s portfolio. Oversight of the performance of a fund also

includes consideration of the fund’s performance relative to its

peers and to benchmark indexes. For target-date funds, however,

comparative peer group data may be more limited because of

significantly different approaches to constructing glide paths.

Thus appropriate benchmarks provide the best metric to measure

performance.

2. Plan participants/individual investors Plan participants and individual investors typically do not have

individualized investment advice at their disposal and rely heavily

on information available through the plan provider or in the public

domain. Selection of an appropriate target-date fund family or fund

entails understanding one’s financial situation and risk preference.

Trying to match these factors with the appropriate fund family

or fund requires an understanding of the drivers of performance

and the risks taken to generate that performance.

A review of best practices in benchmarking target-date funds—and Morningstar’s solution to the problem of finding a suitable benchmark.

Solving the Target-Date Fund Benchmarking ConundrumSanjay Arya, CFA, Senior Vice President, Morningstar IndexesTom Idzorek, CFA, Chief Investment Officer, Ibbotson Associates

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3. Fund manufacturers (and fund managers)One of the many challenges facing target-date fund manufacturers

is an easily digestible method of communicating the portfolio

risk profile of a fund. With an appropriate benchmarking system,

the fund provider can offer a fund investor a yardstick to compare

different target-date funds and at the same time allow them to

objectively measure the value added by the fund manager.

4. Regulators With Congress and the SEC increasing scrutiny on the naming and

marketing of target-date funds, a good, relevant benchmark can

go a long way in defining risk and making sure that the funds do

not stray from their mandates. Similarly dated target-date funds

can have very different asset exposures.

What Cannot Be Measured Cannot Be Managed Despite agreement over the need for benchmarks to serve the

needs of the primary stakeholders, there is no consensus on

the most appropriate way to measure the performance of a target-

date fund or fund family. The four most commonly used benchmark

approaches are summarized next. One of the major problems with

all of these solutions is that they are not dynamic; they assume a

static asset allocation methodology.

1. Single index-relative benchmark By far the most commonly used benchmark for measuring target-

date fund performance is a single-asset class index such as the

S&P 500 or Barclays Capital US Aggregate Index. More than 65%

of the 2020 target-date funds that Morningstar tracks use an equity-

only index as their prospectus benchmark. Even though such an

index is widely followed and easy to understand, it has several

drawbacks. It is wholly composed of stocks, lacks foreign exposure,

and does not match a fund’s risk exposure. Target-date funds,

of course, have stock exposures that are less than 100% and

declining over time. That makes a single-asset class benchmark

increasingly impractical throughout the course of an investor’s

glide path.

2. Custom benchmark Constructing a custom benchmark for an asset allocation fund

involves selecting a benchmark index for each underlying strategy

and then computing a weighted-average performance based on the

neutral asset allocation of the fund. An obvious limitation of this

strategy is that it ignores the manager’s asset allocation acumen,

or lack thereof—which is typically one of the most important

contributing factors to a fund’s performance.

Figure 1: Morningstar® Lifetime Allocation Indexes Three distinct risk profiles address a diverse range of target-date strategies and provide appropriate asset allocation choices for investors.

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2060 2055 2050 2045 2040 2035 2030 2025 2020 2015 2010 2005 2000 Income

Aggressive

Moderate

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••• Morningstar Indexes– Top 20 Largest Target-Date Fund Families

Morningstar Lifetime Aggressive Morningstar Lifetime Moderate Morningstar Lifetime Conservative Top 20 Largest Target-Date Fund Families Source: Morningstar

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3. Blended index benchmark To create this benchmark, an equity index and a bond index will

be combined, typically with an 80/20 or 60/40 weighting. This

approach attempts to address the asset allocation issue, but comes

up short. This is because the weighting is held steady over time,

completely ignoring the glide path.

4. Peer group (universe) benchmarkThis method involves comparing a fund to the performance of a

group of funds with similar mandates (e.g., a specific target

date). Such benchmarks have serious limitations: they are not

investable, are unspecified, and are too broadly defined. Peer

groups also suffer from survivor bias. Survivor bias occurs when

poorly performing mutual funds are terminated or merged into

more successful funds. Within the universe only the track record

of successful funds is maintained, so the poor performance of

terminated funds is not represented in the universe. Additionally,

differing glide paths and a large variance in asset allocations

negate a lot of the benefit of looking at peer groups when

analyzing target-date funds.

Desirable Attributes of Asset Allocation Benchmarks The complexity and problems of measuring the performance of

target-date funds often discourages investors from finding appro-

priate benchmarks and allows many funds to increase relative

performance against a mismatched benchmark. If indexes such as

the S&P 500 or Barclays Capital US Aggregate are not appropriate

measures for target-date funds, what would an appropriate bench-

mark look like? To answer this question, it is helpful to begin by

establishing the characteristics of a good target-date benchmark.

As it pertains to the traditional single-asset class funds, the

CFA Institute curriculum identifies the following characteristics of

a good benchmark:

Unambiguous

Investable

Measurable

Appropriate

Reflective of current investment opinions

Specified in advance

Building on this list, Morningstar believes the following

additional characteristics are desirable attributes of a good

target-date benchmark:

Robust glide path methodologyAmong single-asset class indexes, is generally accepted that the

best weighting scheme for a benchmark is float-adjusted market

capitalization. Early target-date funds used the simple heuristic of

100 minus the investor’s age to determine the amount to invest in

equities and hence the glide path. While an agreed-upon standard

for determining a glide path does not currently exist, a good target-

date benchmark should be based on a transparent, robust glide

path methodology. Ideally such a methodology will recognize the

changing needs of investors and evolve in an appropriate manner.

Robust asset-class specific methodologyA good target-date benchmark should also have a robust method-

ology for determining the intra-stock and intra-bond allocations. We

believe this should include the use of a broad opportunity of asset

classes that allows for maximum diversification in which the asset

classes are mutually exclusive and fully investable. The process for

determining the intra-stock and intra-bond allocations should use

forward-looking capital market expectations and draw upon best

practices in asset allocation such as mean-variance optimization,

liability-relative optimization, utility maximization, and higher

moment optimization techniques.

Robust asset-class specific benchmarksIn this context, recognizing that target-date benchmarks are often

an index of indexes in which the weighting to the sub-indexes

evolves over time, “robust” indicates that the asset-class specific

benchmarks (the sub-indexes) should meet all of the original CFA

Institute curriculum characteristics of a good benchmark.

Our Solution: Morningstar® Lifetime Allocation IndexesThe Morningstar Lifetime Allocation Index family is designed to

meet the benchmarking needs of target-date investors by offering

an objective yardstick for performance comparison. The family

consists of a set of 13 indexes available in five-year increments

across three risk profiles: aggressive, moderate, and conservative.

Morningstar Lifetime Allocation Indexes embody the desirable

attributes of good target-date indexes outlined above, addressing

many of the shortfalls of other target-date benchmarking solutions

as well as competing target-date indexes.

The indexes’ asset allocation methodologies were developed and

are maintained by Ibbotson Associates, a leader in asset allocation

research for more than 30 years and a Morningstar company since

2006. The lifetime allocation strategies, global asset exposures,

risk profiles, and inflation-hedging features are products of

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Ibbotson’s real-world-tested research. Ibbotson’s capital markets

research and annual government survey reviews on consumer

income and net worth are incorporated each summer into the

asset allocations used by the index family. Furthermore, the

Ibbotson methodology is a multifaceted approach that unites the

latest academic research regarding Modern Portfolio Theory

with a sophisticated understanding of human capital’s role in asset

allocation, application of liability-driven investing techniques

to retirees, robust optimization techniques, leading traditional and

alternative asset class research, and 30+ years of asset allocation

thought leadership.

The stock exposures in the index family go beyond U.S. stocks to

include prudent levels of developed and emerging market equities.

The bond allocations include investment-grade bonds—sovereign

debt and U.S. corporate. Preserving purchasing power through

retirement should be a key goal for investors. The Morningstar®

Lifetime Allocation Indexes have allocations to Treasury Inflation-

Protected Securities (TIPS) and commodities to help hedge against

the effects of inflation.

The fundamental building blocks of the Morningstar Lifetime

Allocation Indexes are 14 of Morningstar’s individual asset class

indexes that collectively form a mutually exclusive and nearly

exhaustive opportunity set of asset classes. Morningstar indexes

are designed to be fully investable, objective, and discrete building

blocks that deliver pure asset-class exposure. Each Morningstar

index embodies the current best practices in index construction and

is consistent with characteristics of good benchmarks established

by the CFA Institute.

Conclusion When so many investment decisions rest on comparative analysis

with a benchmark, the quest to design the most appropriate bench-

mark possible for target-date funds is an important endeavor.

A standardized benchmark will add much needed transparency, and

help investors select funds that correlate to their needs, alleviating

much of the criticism target-date funds currently receive. Using

benchmarks like Morningstar’s Lifetime Allocation Indexes will

go a long way to meet the needs of various stakeholders involved

in delivering retirement solutions and ultimately help investors

meet their retirement goals. K

Ibbotson Associates, Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc.